Withdrawal Credits: Pension Plan

What Are Withdrawal Credits: Pension Plan?

A withdrawal credit in a pension plan refers to the portion of an individual’s retirement assets in a qualified pension plan that the employee is entitled to withdraw when they leave a job.

Understanding Withdrawal Credits: Pension Plan

In the context of pension plans, withdrawal credits describe the rights of an employee-participant in a qualified pension plan to withdraw their portion of assets, plus a share of employer contributions, if applicable, upon their departure from that job. Under most pension plans, both the employer and employee make periodic contributions to a fund shared by all eligible employees.

About Distributions

Each individual has an account within that fund, and multiple employers may participate in a single pension fund. When an eligible employee reaches retirement age, they are entitled to periodic distributions that generally equal a percentage of their income in pre-retirement years. An employee who leaves a firm before retirement age likely would be eligible for a partial distribution of their pension funds, depending on the vesting rules established by the employer and the plan.

If you're planning to leave your job, make sure that you roll your retirement funds into another qualified retirement account, as the IRS charges penalties on funds that are not placed in a tax-sheltered account.

Withdrawal Credits: Pension Plan Prior to Retirement

When an employee leaves a firm prior to retirement age, various factors determine the extent to which they are entitled to their pension's balance. Most important among these is their vesting status. Vesting refers to the extent to which the employee has control over their retirement assets.

In most cases, employees' contributions vest immediately, and employees with longer tenures will be entitled to a greater share of employers’ contributions.

The Importance of Rollovers

Because of the tax-exempt status of most retirement funds, departing employees should always roll these funds into a qualified individual retirement account (IRA) administered by a qualified financial institution. The Internal Revenue Service (IRS) charges penalties on funds that are not placed in a tax-sheltered account.

The IRS may consider some special cases such as death or disability when granting exceptions to these requirements. Other potential exceptions include some extreme medical expenses or corrections to a previous over-contribution.

Rules That Govern Withdrawal Credits

For public-sector pensions, withdrawal rules are determined on a state-by-state basis. Private pensions are subject to rules set out in the Employee Retirement Income Security Act (ERISA) of 1974. ERISA and subsequent tax rules outline a complex system of policies regarding vesting and withdrawals from the many variations of defined benefit and contribution plans.

Beyond the ERISA guidelines, employers have the discretion to structure their plans to their own needs. When leaving a company, it's wise to consider your own needs by educating yourself about your options and obligations about withdrawals from qualified retirement plans.

In a pension plan, the responsibility for funding an employee's retirement rests on the employer while, in a defined-contribution plan such as a 401(k), the responsibility falls on the employee.

Defined-Benefit vs. Defined-Contribution Plans

The defined-benefit plan is the most common type of pension plan. A defined-benefit plan is an employer-sponsored retirement plan where employee benefits are computed using a formula that considers several factors, such as length of employment and salary history. Defined-benefit plans guarantee the retiree a set cash distribution upon retirement. Because the employer is responsible for making investment decisions and managing the plan's investments, the employer assumes all the investment and planning risks.

In a defined-contribution plan, like a 401(k) or a 403(b), employees contribute a fixed amount or a percentage of their paychecks to an account that is intended to fund their retirements. The IRS has set an annual contribution limit for 401(k)s and defined-contribution plans. For 2020 and 2021, the maximum contribution limit that an employee can make to a 401(k) is $19,500. Those who are aged 50 or more can make an additional catch-up contribution of $6,500 for both 2020 and 2021.

Sometimes the sponsoring company will match a portion of employee contributions as an added benefit. However, the total contribution between the employee and employer cannot exceed the lesser of $57,000 in 2020 or $63,500, including the $6,500 catch-up contribution for employees aged 50 and over. For 2021, the total contribution must be less than $58,000 or $64,500, including catch-up contributions.

A defined contribution plan is generally comprised of investments, which the employee selects from a curated list of options that often consists of mutual funds. There is no way of knowing how much a defined-contribution plan will ultimately give the employee upon retiring, as contribution levels can change, and the returns on the investments may go up and down.